How likely is a sterling crisis or: is London really Reykjavik-on-Thames?

November 13, 2008

Withthe pound sterling dropping like a stone against most other currenciesand credit default swap rates on long-term UK sovereign debt beginningto edge up, this is a good time to revisit a suggestion I made earlieron a number of occasions (e.g. here, here and here), that there is a non-trivial risk of the UK becoming the next Iceland.

The risk of a triple crisis – a banking crisis, a currency crisisand a sovereign debt default crisis – is always there for countriesthat are afflicted with the inconsistent quartet identified by AnneSibert and myself in our work on Iceland:(1) a small country with (2) a large internationally exposed bankingsector, (3) a currency that is not a global reserve currency and (4)limited fiscal capacity.

The argument is simple. First consider the case where the bankingsector is fundamentally solvent, in the sense that its assets, if heldto maturity, would cover its liabilities. Iceland’s banks were supposedto have been in that position, although I have seen no verifiableinformation on the quality of the three formerly internationally activebanks. There is no such thing as a safe bank, even if the bank issound. Without an explicit or implicit government guarantee, there isalways the risk of a bank run (a withdrawal of deposits or a refusal torenew maturing credit and to roll over maturing debt) or a suddenmarket seizure or ’strike’ in the markets for the bank’s assetsbringing down a fundamentally sound bank.

To prevent a fundamentally sound bank succumbing to a deposit run orto asset market illiquidity, the central bank has to be able to act aslender of last resort, providing funding liquidity and as market makerof last resort, providing market liquidity to liquidity-constrainedbanks.

If the country has an internationally active banking and financialsector and if its foreign currency liabilities have a shorter maturitythan its foreign currency assets, and especially if these foreigncurrency assets have become illiquid, the central bank has to be ableto act as foreign currency lender of last resort and market maker oflast resort if it is to be able to guarantee the survival of thebanking sector when faced with a deposit run and/or illiquid marketsfor its assets.

The central bank of Iceland could be an effective lender of lastresort in Icelandic krona, as it can print the stuff in unlimitedquantities. It can be a lender of last resort and market maker of lastresort in other currencies only to a limited extend – limited by thefact that the Icelandic krona is not a global reserve currency and bythe fiscal spare capacity of the Icelandic sovereign.

If Iceland had been a member of the euro area, its central bankwould have been part of the Eurosystem – the euro area central bankconsisting of the ECB and the (currently 15) national central banks ofthe euro area member states. The euro is the junior of the two globalreserve currencies. First is the US dollar, with around 64 percent ofglobal official foreign exchange reserves held in US dollars. Theeuro’s share is around 27 percent. After the euro, there is nothing.Sterling’s share of 4.7 percent (at the overly flattering strongsterling exchange rate of late 2007) reflects its minor-league legacyreserve currency status. The Japanese yen and Swiss franc arecompletely irrelevant as global reserve currencies.

Clearly if a country has a major-league global reserve currency asits national currency, two consequences follow. First, it is likely tobe able to borrow abroad using instruments denominated in its owncurrency rather than in that of the currency of the lender or someother global reserve currency – they are less affected by ‘originalsin’ – in the currency-denomination-of-external-debt sense of theexpression. Second, it will be possible for both private parties andfor official parties like the central bank, to arrange access toforeign exchange (through swaps with other central banks, credit linesetc.) more easily and on better terms than are available to privateparties, central banks and other official agents not blessed with aglobal reserve currency of their own.

As a member of the euro area, it would have been much easier andcheaper for Iceland to defend itself against speculative attacks on itsbanks – provided the banks and its government were indeed solvent andperceived to be so. With the krona, not only could solvent banks bebrought down, even a solvent but illiquid (in foreign exchange)government could be brought down by a sufficiently large speculativeattack on the banks, the currency and the public debt.

Of course, even with the euro, the banks could not have been savedby the Icelandic authorities if the banks were fundamentally unsoundand if the government did not have the fiscal strength to recapitalisethe banks. Under current circumstances, if the government injectscapital into a bank to compensate for past and anticipated futurelosses, it may not achieve a risk-adjusted expected rate of return onthis investment equal to its borrowing cost. The difference will haveto be recouped through higher future primary surpluses, that is, higherfuture government budget surpluses excluding interest payments. Ifthere is doubt in the markets about the ability or willingness ofcurrent and/or future governments to raise future taxes or cut futurespending to generate the required increase in future primary surpluses,the default risk premium on the public debt will rise. We are seeingsuch increased default risk premia even for the most credit-worthysovereigns, including the German government, the US government and theUK government. On Friday October 10, 2008, the spreads on 5 yearsovereign CDS were 0.456% for the UK, 0.33% for the USA ad 0.265% forGermany, well above their post-war historical averages. On October 28,2008, Bloomberg wrote:

“Credit-default swaps on [U.S.] Treasuries haverisen nearly 40 percent since TARP was signed into law Oct. 3, and arenow about the same as Mexican and Thai government debt before thecredit markets began to seize up in June 2007.”

By bailing out the banks, and other bits of the financial system,the authorities reduce bank default risk but by increasing sovereigndefault risk. As long as there is sufficient fiscal spare capacity (thetechnical, economic and political prerequisites are met for raisingfuture taxes and/or cutting future public spending by a sufficientamount to service the additional public debt and maintain long-rungovernment solvency).

Iceland’s government did not have the fiscal resources to bail outits banks. All three internationally active banks were put intoreceivership. The domestic bits then were bought by the government outof the receivership. The Icelandic krona collapsed and is no longerinternationally convertible: exchange rate restrictions have beenimposed. It is an open issue whether Iceland will default on some ofits sovereign debt obligations as well.

How and to what degree is this relevant to the UK? Iceland is a tinycountry (about 300,000 people – the size of the city of Coventry). TheUK has a population of over 61 million. Nevertheless, the UK is a smallopen economy for economic purposes: it is a price taker in the marketsfor its imports and exports and in global financial markets. Its shareof world GDP in 2007 was 3.3% (at PPP exchange rates – somewhat higherat market exchange rates). Its currency is no longer a serious worldreserve currency.

The UK banking sector’s balance sheet is about half the size of theIcelandic banking sector as a share of annual GDP: just under 450% atthe end of 2007 as compared to Iceland’s almo
st 900%. Switzerland,another vulnerable country (small, no currency with global reservecurrency status , large banking sector relative to GDP and limitedcentral government fiscal capacity) has a banking sector balance sheetof just over 650% of annual GDP. With UK annual GDP around £1.5trillion, that gives us a banking sector balance sheet of well over £ 6trillion.

The first Chart below shows the size of the balance of the UKbanking sector. This includes the Bank of England. If we exclude theBank of England, the latest observation on the balance sheet of thebanking sector and a percentage of annual GDP would still be around 420percent. The deleveraging of the banking sector, visible at the veryend of the sample period, has much further to go. The Chart also showsthat foreign currency assets and liabilities of the banking sector arevery evenly matched – the two lines are almost indistinguishable. Bothnow are just below 250% of GDP. I don’t have any data on the degree ofmismatch by individual currency. Just the aggregate foreign currencyexposure is shown.

While there is no net foreign exchange exposure of the bankingsystem in the UK, banks are banks. The foreign currency liabilities ofthe banking system are therefore likely to have shorter maturities thanthe foreign currency assets. The foreign currency assets are alsolikely to be less liquid than the liabilities. I don’t have informationon the maturity and liquidity composition of foreign currency assetsand liabilities to confirm or refute this presumption. Let me just saythat Iceland’s banks were brought down despite an aggregate matchbetween foreign currency assets and foreign liabilities.

Chart 1

Source: Office for National Statistics

Not only are the UK banks rather large relative to the size of theeconomy, the gross external assets and liabilities of the Britisheconomy are also hefty – about the same size relative to UK GDP as thetotal assets of the banking sector (there is no deep reason for thiscoincidence). Chart 2 below shows the gross external asset andliability position and the net foreign investment position of the UK.While not in the Iceland league (Iceland had gross foreign assets andliabilities of around 800 percent of annual GDP at the end of 2007) theUK, with gross foreign assets and liabilities of well over 400 percentof annual GDP does look like a highly leveraged entity – like aninvestment bank or a hedge fund. By contrast, gross external assets andliabilities of the US straddle 100 percent of annual GDP.

Chart 2

Source: Office for National Statistics

Foreign currency illiquidity risk for the UK banks and authorities

Assume for the sake of argument that the UK’s banks are sound. Mostof them obviously are not, which is why so many of them have hadcapital injected into them by the government, and why all of thembenefit from explicit government guarantees on new bank debt issuanceand implicit government guarantees that the government will come totheir assistance should they be at risk of insolvency. With foreigncurrency assets of longer maturity and less liquid than foreignliabilities, the banks and the country would still be vulnerable to aforeign currency run on the banks (a refusal to renew foreign currencycredit) or a seizing up of the markets in which the banks’ foreigncurrency assets are traded. The Bank of England’s foreign currencyreserves are puny and the government’s foreign currency reserves aresmall – around US$43 billion, pocket change, really.

No doubt the Bank of England would be able to arrange swaps, creditlines or overdraft facilities with the systemically important centralbanks – the Fed, the ECB and the Bank of Japan. Given sound banks andsound fiscal fundamentals, it should be possible for the UK to defendthe banking sector against runs or market strikes. There would,however, be a cost involved – the cost faced by any issuer of acurrency that is not a global reserve currency and who therefore eitherhas to insure ex-ante against the possibility of running short ofglobal reserve currencies, or risk getting clobbered on the terms of anemergency currency swap or similar arrangement cobbled together whenthe enemies are already scaling the ramparts.

This cost of insuring against foreign currency illiquidity risk willmake the City of London less competitive as a global financial centerthan rivals based in global reserve currency jurisdictions. It providesanother strong argument for the UK adopting the euro and for the Bankof England becoming part of the Eurosystem as soon as the other EUmember states will let it.

The reason the costly handicap of a minor-league currency does notappear to have harmed the UK in the past is the same as the reason whyI have not made the argument in the past. Before the current financialcrisis, no-one could conceive of a world in which a financial crisiswould start in the global financial heartland – Wall Street and theCity of London – rather than in some developing country or emergingmarket, would paralyze most systemically important wholesale financialmarkets and lead to the government nationalising much of the northAtlantic region’s banking and wider financial system and underwritingor guaranteeing the rest. Well, most of the world now knows that thisis the way things can be. If it retains sterling, the City of Londonwill put itself at a competitive disadvantage (for those who rememberthen-Chancellor Brown’s Five Tests for euro area membership, this meansthat the fourth of these tests now has been met also).

Sovereign default risk for the UK

Even if the UK had the euro as its currency, its banks would stillhave been at risk if they were unsound (their assets, even if held tomaturity, would not cover their financial obligations). In this case,bank insolvency would result unless the British authorities were bothable and willing to bail them out. I assume in what follows that thegovernment is willing to bail out the banks. The evidence thus farsupports this.

Northern Rock and (rump) Bradford and Bingley were nationalised. TheSLS allows all banks to swap illiquid asset-backed securities forTreasury Bills. For reasons that cannot be understood by ordinarymortals, the Treasury Bills lent/swapped by the SLS don’t count aspublic debt (something to do with Treasury bills with less than oneyear remaining maturity not being part of the public debt for someaccounting and accountability purposes – don’t ask). The Bank ofEngland is accepting a wider range of private securities as collateralat the discount window and in repos. The state has a 60 percentownership stake in RBS and roughly 40 percent ownership stakes in HBOSand Lloyds-TSB. The government has made up to £25o billion available toguarantee new issuance of bank debt. The state stands behind the formal£50,000 deposit guarantee for bank retail deposits.

The key question is, can the government meet all these fiscalcommitments, whether firm or flaccid, unconditional or contingent andexplicit or implicit ? Does it have the resources, now and in thefuture, to issue the additional debt required to meet the growingvolume of up-front obligations it has taken on?

To be solvent, the face value of the government’s net financialobligations has to be no larger than the present discounted value ofcurrent and future primary government surpluses (government surplusesexcluding net interest and other investment income). The governmentargues that its net debt position is strong, with a net debt to annualGDP ratio still just below forty percent. That statistic is a primeexampl
e of lies, damned lies and government statistics.

The 40 percent excludes such old sins as the debt incurred throughthe PFI (private finance initiatives). This will be brought into thetotal soon. It also does not yet include the net debt of Northern Rockand Bradford and Bingley. It also excludes the debt of RBS, where thegovernment owns a majority stake and the debt of Lloyds-TSB and HBOS,where the government has a controlling minority stake. Under normalaccounting practices, the debt of all three banks will have to becounted as public debt in the future.

Three large UK banks, HSBC, Barclays and Abbey (Santander) have notyet taken the King’s shilling – they are attempting to meet the capitalraising targets they agreed with the government from sources other thanthe government. All three banks are, however, heavily exposed toemerging markets (Santander mainly in Latin America, HSBC in Asia, theAmericas, Europe, the Middle East, and Africa and Barclays in Europe,Africa and Asia). This has been a source of strength until recently,compared to their competitors who were mainly exposed to the USA andWestern Europe. However, with all emerging markets now severelyaffected by the financial crisis (both directly and through trade linkswith Western Europe and the USA), what was a source of strength isbecome a further source of weakness. The likelihood that some or all ofthe banks that have not yet received capital injections from thegovernment will do so in the not too distant future is rising steadily.

It is not at all far-fetched to hold the view that the Britishgovernment has effectively guaranteed the balance sheets of the entireUK banking sector. Let’s value this conservatively at 400 percent ofannual GDP, some £ 6 trillion. The value of this guarantee depends onthe likelihood it will be called upon, and on the amount of money thegovernment would have to come up with if the guarantee is called. Bothnumbers are highly uncertain and any guestimate is bound to besubjective. The expected payments under the guarantee are, in my view,hardly likely to be less than £300 bn (on top of any money already paidout), some 20 percent of annual GDP. It could be much higher. With arecession of unknown depth and duration looming, there is a materialrisk that the government would have to come up with a multiple of the£300 bn just mentioned.

Of course, the value of the assets acquired by the government asshareholder has to be set against the explicit and implicit liabilitiesit has taken on. I would like to see a valuation of the equity stakesof the government that does not benefit from the recent scandalousrelaxation of fair-value accounting and reporting that was forced uponthe IASB. I don’t believe any valuation that relies on managerialdiscretion. With the regulatory constraints likely to be imposed onbanks in the future, and the lower returns associated withbanking-as-a-public utility, the government may well be getting ratherpoor financial returns on its investment in the banks. While that doesnot mean the government should not have made the capital injections -the systemic externalities associated with the failure of large banksdon’t show up in the share price – it does mean that the immediatefiscal burden of the capital injections is likely to be only partiallyoffset by future dividends and (re-)privatisation receipts.

In addition to the debt that has been and will be issued to financeasset purchases by the government, there are the future debt issuanceassociated with the large cyclical and structural government deficitsthat will be a feature of the coming recession. If GDP fallspeak-to-trough by, say 3.5 percent and recovers only slowly, we couldhave a seven percent of GDP or higher government deficit for 2009 and2010. Together with the explicit or implicit fiscal commitments made tosafeguard the British banking system, the numbers are likely to spookthe markets.

With the true net public debt to GDP ratio probably already wellabove 100 percent of GDP and rising, and with massive public sectordeficits, partly cyclical and partly structural, about to materialise,the markets will question the fiscal-financial sustainability of thegovernment’s programme with increasing vehemence. The CDS spreads on UKpublic debt will start rising. The notion that, except for currency,there may not be a safe sterling-denominated asset may come as a shock.But the same is true in the US. In 2009, the US government will have tosell (gross) at least $ 2 trillion worth of government debt (the sum ofthe Federal deficit plus asset purchases plus refinancing of maturingdebt). The largest such figure ever in the past was $550 billion. Inthe US too, the markets will have to learn to do without a US dollarfinancial instrument that is free of default risk.

The fiscal dire straits the UK government are in limits theircapacity to engage in a discretionary fiscal stimulus to boost domesticdemand. For it to be meaningful, a debt or money-financed stimulus ofat least one percent of GDP and more likely two percent of GDP iscalled for. But if the market takes fright and believes that thegovernment will not raise future taxes or cut future public spending bythe amounts required to safeguard government solvency despite greatercurrent borrowing, it will add higher default risk premia to thelonger-dated UK sovereign debt instruments.

Such mistrust in the temporary nature of a fiscal stimulus would notbe irrational. After its first term in office, the government havethrown fiscal restraint to the wind and have engaged in a steadyincrease in public spending as a share of GDP which has been onlypartly matched by an increase in the tax burden as a share of GDP.Rising debt and deficits and a fondness for fiscal and accountinggimmicks designed to hide the increase in the debt burden haveundermined public confidence in the fiscal rectitude of the government.With enough mistrust, the interest rates will rise by enough to crowdout completely the stimulus to private demand provided by the tax cutor public spending increase. Lack of confidence in the government’sfiscal sustainability would also undermine confidence in sterling. Inthe worst case, we could see a run on the banks, on the public debt andon sterling all at the same time. This is not the most likely outcomeyet, in my view. But it is a distinct possibility.

Could the government monetise the deficits instead (i.e. sell giltsto the bank of England)? The Bank would only be willing to buy suchdebt (either directly or indirectly in the secondary markets) if it wasconsistent with its interpretation of its price stability mandate. TheBank appears to believe that short rates may have to go down quite abit further if it is not to undershoot the inflation target by the endof next year. It may also view the monetisation of gilt issuance asconsistent with its mandate.

If there is a conflict between the Bank of England and thegovernment, the government could invoke the Treasury’s Reserve Powers.This is a clause in the Bank of England Act that allows the governmentto take back the power to set rates from the Bank of England, underexceptional and emergency conditions. It has never been invoked.

If the deficits get monetised, there will not be the upward pressureon real interest rates that would result from debt financing. But themarkets may fear the long-term inflationary consequences of themonetary financing, especially if it were to be done by the governmentafter invoking the Treasury’s Reserve Powers. So long nominal rateswould be likely to rise if monetisation of the government’s deficitswere chosen. Monetisation of deficits would also weaken sterlingfurther.

All may still end up well (cyclically adjusted well, that is). Butthe piling of fiscal commitment on fiscal commitment by the governmentis not a risk-free option. The British government has limited fiscalspare capacity. Among the larger European countries, the UKgovernment’s exposure, formal or implicit, to its banking sector is byfar the highest. Switzerland, Denmark and Sweden are in a similarpickle, with the
banking sector solvency gap threatening to becomelarger than the fiscal spare capacity of the state.

The British government should go easy on the discretionary fiscalstimulus it applies, lest it risk a triple bank, sterling and publicdebt crisis. Better to first let the Bank of England use the 300 basispoints worth of Bank Rate cuts that it still can play with. Even betterto combine rate cuts with measures to directly target thedisfunctionalities in the interbank market, such as governmentguarantees for (cross-border) interbank lending.

The UK shares with the United States of America the predicament thatunfavourable fiscal circumstances make the wisdom of a significantfiscal stimulus questionable. In the US as in the UK the twin deficits(government and current account) severely constrain the government’sfiscal elbow room. Both countries need all the help they can get fromfiscal stimuli abroad, in China, in Germany and in the Gulf. Beggarscan’t be choosers.